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Takeaway:  While we suggested covering some in late September, the recent disclosures leave us more bearish and suggest our thesis is on track.  Cat Financial apparently goosed 3Q15 results by changing model assumptions, adding an estimated 6 percentage points to the segment margin with an accounting maneuver.  Caterpillar Financial cut the Allowance for loan losses amid unfavorable changes in credit quality, which seems odd.  We can’t wait to hear CAT’s presentation on the Finance segment on November 17th, although we do not expect it to provide the data and granularity that investors want.  The various investigations appear to have expanded, and the company’s postretirement benefit underfunding should increase next year.  Overall, CAT’s 10-Q, proposed meeting on Cat Financial, and GS conference presentation continue to suggest further downside to us.

Key Earlier Publications

Feeling Used? CAT Black Book (latest of many)

In Rehab?  Would Reduce Short Exposure For Now (9/25/15)

Barron’s article response (8/8/15)

It Gets Worse From Here (7/23/15)

Writing On The Wall

“During the third quarter of 2015, as a result of management’s review, the loss emergence period and loss given default assumptions were updated and resulted in a decrease to the allowance for credit losses of $45 million. The decrease in the provision for credit losses was also due to the absence of a $14 million out-of-period adjustment in the third quarter of 2014 (included in the discussion above). These changes were partially offset by an unfavorable impact from changes in the credit quality of Cat Financial’s portfolio.”

Our Translation:  Credit quality deteriorated, but we changed some model assumptions so that deterioration didn’t impact earnings.

CAT | Naughty - CAT 11 4 15

Not Healthy:  If you come home, and a three year old says “I didn’t draw on the wall” do you bother to check, or do you just grab Mr. Clean Magic Eraser?  An unprompted denial usually doesn’t indicate anything good.  For CAT, the assertion that “our captive finance company is healthy and strong” was a similar red flag in the 3Q15 earnings release, and would have been tough to defend had margins dropped over 6 percentage points.  Write-offs were higher only in 2 quarters over the last dozen years, with both of those during the Financial Crisis.  Healthy?

CAT | Naughty - CAT 2 11 4 15

One Quarter Fix, Future Earnings At Risk:  Amazingly, that disclosure on the $45 million benefit from an accounting assumption change did not make the press release or earnings call, at least that we saw.  But the drop in allowance was highlighted.  To quote Josh Steiner of our Financials team “taking reserves, not just reserve coverage, down amid (sharply) rising NPLs is reckless and aggressive. Any traditional lender would face villagers/pitchforks for this.”  

Do You Know Who They Lent To?  Here is part of the list of Caterpillar Financial mining Major Accounts from our June 2015 deck.  As we understand it, these are not necessarily included in the Mining category of the portfolio in disclosures, but may be in regional buckets.  

CAT | Naughty - CAT 3 11 4 15

Problems Outside of Caterpillar Financial

Backlog Longer Than 12 Months:  It is worth noting that CAT’s order backlog is getting somewhat longer dated, which is not positive for 2016 since the total order backlog is lower.  It could also indicate that some delivery dates have been pushed out.

CAT | Naughty - CAT 4 11 4 15

Investigations Expanding

CAT has so many legal issues, that it can be hard to keep track of them.  The key investigations seem to be heading in the wrong direction for investors as of 3Q15.  The Federal grand jury investigation into CAT’s taxes apparently expanded, with additional subpoenas for, among other things, information on “dividend distributions of certain non-U.S. Caterpillar subsidiaries, and Caterpillar SARL and related structures.”  The pressure on this does not seem to be easing, and it could be an expensive settlement for CAT, as we understand it.  The investigation by the SEC into the accounting for the Bucyrus acquisition also generated additional subpoenas, and we think management should just restate, impair, pay a fine, or whatever is needed to get it over with, in our view.  

Pension Losses May Impact 2016 Earnings

CAT disclosed in the 10-Q that “Based on market conditions as of September 30, 2015, we would be required to recognize an increase in our underfunded status of approximately $800 million at December 31, 2015.” The driver of the pension challenges was “due to year-to-date negative plan asset returns”.  All else equal, this could increase pension expense in 2016 – a year that likely won’t need additional profit challenges. 

 

November 17th Cat Financial Meeting For Investors

The last one of these meetings, which was on the Across the Table dealer initiative, was not especially helpful.  We would be very surprised if this upcoming meeting on November 17th had the data and granularity that investors actually want.  We hope that CAT decides to provide more transparency on the composition and exposures in the portfolio, but our expectation is that it will be a narrative driven presentation.

Upshot:  While we suggested covering some in late September, the recent disclosures leave us more bearish and suggest our thesis is on track.  Cat Financial apparently goosed 3Q15 results by changing model assumptions, adding an estimated 6 percentage points to the segment margin with an accounting maneuver.  Caterpillar Financial cut the Allowance for loan losses amid unfavorable changes in credit quality, which seems odd.  We can’t wait to hear CAT’s presentation on the Finance segment on November 17th, although we do not expect it to provide the data and granularity that investors want.  The various investigations appear to have expanded, and the company’s postretirement benefit underfunding should increase next year.  Overall, CAT’s 10-Q, proposed meeting on Cat Financial, and GS conference presentation continue to suggest further downside to us.